Eastern Europe was hit especially hard by the credit crunch during the global financial crisis. This column presents new evidence suggesting that reliance on foreign funding was more important than foreign bank ownership per se in exacerbating the post-crisis credit contraction. These findings point to the need to put more emphasis on the discussion of bank business models, regulatory standards, and supervisory arrangements.

From boom to crunch

Although most developing countries around the world experienced a severe contraction of bank credit during the recent global financial crisis, the Eastern Europe and Central Asia (ECA) region was disproportionately hit after it had experienced very high credit growth (Figure 1).

Figure 1. Banking system trends in ECA

One possible explanation for such a protracted decline lies in the ECA region’s close economic and financial links with western Europe, including a high degree of foreign ownership of banks and a high reliance on more fickle cross-border wholesale funding. This exposed the ECA region disproportionately to stress faced by globally active western European banks (De Haas and Van Lelyveld 2012, De Haas and Van Horen 2013).
Indeed, the weaknesses of this banking business model and the cross-border supervisory context in which it operated were exposed when the fallout of the US subprime crisis reached Europe and both bank funding and solvency conditions deteriorated rapidly, triggering western European banks to repair their balance sheets and retrench to their home markets. A concerted policy response – including the Vienna Initiative – was necessary to mitigate the severity of the credit contraction in the ECA region (De Haas et al. 2012).

A renewed debate on foreign bank presence

These events have triggered a renewed debate about the costs and benefits of cross-border finance and financial integration in general, and the presence of foreign banks in particular.

One potential weakness of this research, however, is the reliance on bank-level data that does not provide sufficient granularity on funding structures. Specifically, there is no data on the levels of foreign funding in previously used data sources.

To address this, we construct a global country panel with quarterly data for 41 countries in Africa, Asia, eastern Europe and central Asia, Latin America, and the Middle East for the period 2000–2011, which allows us to explicitly measure domestic banks’ overall reliance on foreign funding relative to total liabilities (Feyen et al. 2014).

We also adopt a different methodology to that prevalent in the literature – panel vector autoregressions (PVARs) – to examine the dynamic relationship between funding structures and credit growth. In particular, our PVARs simultaneously model the dynamic interaction between the quarterly growth rates of private bank credit, domestic bank deposits and bank foreign liabilities (reflecting the funding model), and GDP (capturing demand effects). At the same time, the PVARs account for country-fixed effects to address time-invariant characteristics that influence the relationships in the system, such as the institutional structure in a country, the rule of law, credit information, and other relatively static features of the business environment. Finally, year-fixed effects capture global shocks affecting finance and growth, such as the effect of the recent financial crisis that is common for all countries in the same quarter.

Ownership or funding models?

The PVARs show that private credit growth is highly sensitive to cross-border funding shocks (i.e. shocks to banks’ foreign liabilities) around the world, and particularly sensitive in the average ECA country. The response in the ECA region is 72% larger compared to the average country in the rest of the world in the initial period the funding shock hits, and remains three times larger in subsequent quarters (Figure 2).

Figure 2. ECA is more vulnerable to foreign funding shocks on credit growth

Furthermore, our PVARs show that in general, countries with high reliance on foreign funding (i.e. large foreign liabilities relative to domestic deposits) exhibit a much stronger response of private credit to foreign funding shocks. Intuitively, high reliance on foreign funding signifies heightened sensitivity to foreign shocks.

To demonstrate this, we split our sample into countries with high and low foreign funding reliance, based on the median level of foreign funding reliance right before the crisis erupted. Figure 3A shows this result by plotting the differential impulse-response function over six quarters of credit growth to a funding shock between these two subsamples. One can see that the difference is positive and statistically significant (i.e. the confidence interval around the central impulse point estimate line is above zero during the first few quarters after the shock hits the system).

Notes: The graphs show the differential response over 6 quarters of credit growth (%) to a foreign funding shock between 2 subsamples, respectively. The center line represents the impulse-response point estimate. The outer 2 lines represent 5% and 95% confidence intervals.

In contrast, Figure 4A does not show a significantly different response when the sample is split based on the median level of pre-crisis foreign ownership.

Figure 4. Foreign ownership per se does not matter

Notes: The graphs show the differential response over 6 quarters of credit growth (%) to a foreign funding shock between 2 subsamples. The center line represents the impulse-response point estimate. The outer 2 lines represent 5% and 95% confidence intervals.

In other words, these results suggest that funding models matter, not foreign ownership per se.

Looking at eastern Europe and central Asia more closely

While suggestive, these results do not show directly that this is the case for the ECA region. To demonstrate this, we construct ‘truncated’ ECA samples which resemble non-ECA countries, and compare their PVAR results to those of the rest of the world.

In the first truncated ECA sample, we remove countries from the ECA sample with weak funding models (e.g. high reliance of foreign funding). If weak funding models drove the ECA credit crunch, we should no longer observe a differential response with the rest of the world. Figure 3B shows this is indeed the case, despite the fact that the average foreign funding reliance in the ECA region is still higher than in the rest of the world.

In another truncated ECA sample, we only remove countries with very high levels of foreign ownership. Foreign ownership in the average ECA country in the resulting sample is statistically no longer different from the rest of the world. Yet, Figure 4B shows that the differential response persists.

In all, these results provide more direct evidence that a fragile funding model was a key factor in explaining the higher sensitivity of private bank credit growth to foreign funding shocks in the ECA region, while high foreign ownership levels per se did not account for this.

Some policy implications

Our findings provide an illustration of the downside risks of cross-border finance or financial integration in the absence of adequate regulatory and supervisory frameworks. However, rather than trying to curtail and scale back foreign bank presence, our results suggest regulators ought to focus on the business models of local affiliates of international banks and the regulation of cross-border funding.

The ‘Spanish’ or ‘Santander’ model in which standalone subsidiaries are capitalised and funded locally is a relevant benchmark for the ECA region. However, eradicating cross-border funding altogether and promoting a fully domestically funded subsidiary model also appears suboptimal as it may lead to costly pockets of inert liquidity and capital within banking groups.

Therefore, home and host regulators in Europe face the challenge of designing an effective regulatory framework for cross-border banking. Such a framework may include supplements to Basel III to prevent the funding and credit growth excesses of the past decade and the risk of another crisis, while allowing banking institutions to benefit from the centralised management of capital, liquidity, and funding.

Honorary Senior Fellow and Simon Industrial Fellow, University of Manchester; Adjunct Professor of Finance, University of Lusaka; Lead Financial Sector Specialist in the European and Central Asia region, The World Bank